On May 5, New York Attorney General Letitia James announced a landmark legislative proposal — titled the Crypto Regulation, Protection, Transparency and Oversight Act — to tighten regulations on the digital asset industry. The proposal, which James called "the strongest and most comprehensive set of regulations on cryptocurrency in the nation,"[1] has the stated purpose to "protect customers and investors in digital assets from fraudulent practices, eliminate conflicts of interest and increase transparency."[2] It would add a new layer of regulation on top of the existing regulatory framework for digital assets in the state, i.e., the BitLicense regime, and could challenge the business models of many digital asset companies that currently operate from or within New York state. Thus far, New York state's digital asset activities are primarily regulated by the New York State Department of Financial Services, which is the administrator of the BitLicense regime. The BitLicense — which the DFS finalized in June 2015 — was the first comprehensive regulatory framework specifically designed for firms dealing in "virtual currency," defined by the DFS as "any type of digital unit that is used as a medium of exchange or a form of digitally stored value," regardless of whether it is centrally managed or decentralized.[3] Since then, 24 BitLicenses have been issued by the DFS, and the DFS supervises an additional nine firms that have obtained a limited purpose trust charter under the New York Banking Law for the purpose of engaging in "virtual currency business activity."[4] In comparison to the BitLicense regime, which focuses on business activities specifically involving virtual currencies, the proposal would broadly apply to all digital assets, including but not limited to virtual currencies and any other coins, tokens and digital assets that "can be used as a medium of exchange, a form of digitally stored value, or a unit of account," regardless of whether it is centrally managed or decentralized.[5] The definition of "digital asset," on its face, could apply to a token that does not currently fit the definition of "virtual currency" under the BitLicense regime because it is not used as a medium of exchange or stored value but that nevertheless qualifies as a digital asset under the proposal because it has the potential to be used for that purpose. The proposal defines five categories of digital asset participants that would be subject to all or parts of the law: digital asset issuer,[6] digital asset broker,[7] digital asset marketplace,[8] digital asset investment adviser[9] and digital asset influencer.[10]
The last of these — digital asset influencer — appears to draw inspiration from the antitouting provision of the federal securities laws, which has subjected a number of celebrities to U.S. Securities and Exchange Commission enforcement.[11] According to the proposal, any person who "widely promotes, publishes, publicizes, or circulates" any notice, advertisement, or electronic posting or communication, among others, that encourages investment in a digital asset, where such person receives compensation or owns, or expects to own such digital asset, in the amount of $25,000 or more in value, would be a digital asset influencer. Given the low-dollar threshold and the lack of clarity around what it means to "widely" promote something, this definition has the potential to subject a number of digital asset enthusiasts and owners[12] to additional registration and disclosure rules, as we discuss in more detail below. The proposal would prevent common ownership of digital asset issuers, digital asset marketplaces, digital asset brokers and digital asset investment advisers; prevent any person from engaging in more than one of these activities; prevent digital asset brokers and digital asset marketplaces from proprietary trading; require public reporting of financial statements; and require digital asset brokers and digital asset investment advisers to reimburse customers for certain types of self-reported unauthorized transfers. It would also codify the DFS' authority to supervise and examine digital asset issuers, digital asset brokers, digital asset marketplaces and digital asset investment advisers, and it would allow the DFS to oversee the digital asset licensing regime. Finally, it would require digital asset influencers to register with the Office of the Attorney General and to submit certain disclosures prior to engaging in any promotion of digital assets. Digital asset issuers, brokers, marketplaces and investment advisers would be required to publicly post a certification of compliance with all requirements of the proposal before operating from or within New York state. The proposal is another example of James' increasingly aggressive approach to regulating digital assets using her office's own powers, as opposed to relying on the DFS. In 2021, the attorney general's office issued an industry alert reminding crypto brokers, dealers, salespersons and investment advisers to register with the office's Investor Protection Bureau,[13] and it directed several platforms to cease activities in New York state for failure to register under the Martin Act.[14] Since then, the office has filed suits against a number of crypto platforms, including a suit in March against KuCoin, a crypto exchange, for failing to register as a securities and commodities broker-dealer.[15] While the proposal codifies the BitLicense regime and has received endorsements from five state senators, seven assembly members and former DFS Superintendent Maria T. Vullo,[16] it adds to the attorney general's powers in myriad ways, and as of the date of publication of this article, current DFS Superintendent Adrienne A. Harris notably has not endorsed the proposal.
Instead, when asked to comment, the DFS defended its record on virtual currency regulation, stating that it is the "only prudential regulator with virtual asset-specific authority in the United States" and that it is "DFS's priority to ensure that consumers and markets are protected and New York continues to be the global financial center."[17] The Office of the Attorney General will work with the state Senate and Assembly to introduce the proposal for consideration during the 2023 legislative session, which is scheduled to adjourn on June 8. Despite James' enviable record of getting legislation she supports passed, time is short for doing so in 2023. The bill, once introduced, will be available for consideration until the end of the current legislative session in 2024. If passed and signed into law, the proposal could challenge the business models of many existing digital asset companies that currently operate from or within New York state — for example, many exchanges currently offer services that could qualify them simultaneously as a digital asset broker, digital asset marketplace and digital asset investment adviser under the proposal. Digital asset industry participants to whom this proposal would apply should therefore review it and their existing practices, and evaluate the extent of the impact this proposal might have on the way they operate their business. They should also consider actively engaging in the legislative process, including attending any public hearings to identify and address potential concerns or issues with the proposal. Key Points The proposal aims to protect New York state investors by bringing to the digital asset industry regulations and oversight that are applied to certain other financial services, while also addressing other practices that are unique to digital assets.[18] The proposal focuses on consumer protection related to three areas: (1) preventing conflicts of interest, (2) promoting financial transparency and (3) bolstering investor protection. Preventing Conflicts of Interest The proposal seeks to prevent conflicts of interest in the digital asset industry by: • Prohibiting any participant or its affiliate(s) from acting as more than one of the following: a digital asset issuer, digital asset broker, digital asset marketplace or digital asset investment adviser;[19] • Preventing digital asset issuers, digital asset marketplaces, digital asset brokers and digital asset investment advisers or any of their affiliates from engaging in proprietary trading;
• Prohibiting digital asset marketplaces and digital asset investment advisers from keeping custody of customer funds; • Requiring digital asset brokers to maintain "physical possession or control"[20] of customer assets, and prohibiting them from borrowing or lending customer assets; and • Prohibiting digital asset brokers from making referrals to digital asset investment advisers or digital asset issuers for compensation. Promoting Financial Transparency The proposal seeks to increase transparency in the digital asset industry by: • Requiring digital asset issuers, brokers, marketplaces and investment advisers to undergo independent financial audits and disclose annual and quarterly audited financial statements; • Requiring digital asset issuers to publish a prospectus prior to the issuance of any digital asset that includes material information about the digital asset issuer and the digital asset;[21] • Requiring digital asset brokers to disclose to their customers "any fees to be received from any source whatsoever" immediately prior to effecting a transaction on behalf of the customers; • Requiring digital asset marketplaces to establish and publish listing standards;[22] • Requiring digital asset brokers and digital asset marketplaces to publish the price and volume of any "off-chain transaction"[23] within 10 seconds of such a transaction; and • Requiring digital asset influencers to register and report their interest in any digital asset issuer whose digital assets they promote.
Bolstering Investor Protection The proposal attempts to bolster investor protection in the digital asset industry by: • Requiring digital asset brokers and digital asset investment advisers to implement anti-money laundering and "know your customer" procedures in compliance with state and federal rules; • Banning the use of the term "stablecoin" to describe or market digital assets unless they are backed 1:1 with U.S. dollars or certain high-quality liquid assets; • Prohibiting digital asset brokers from effecting "cross transactions";[24] • Prohibiting digital asset marketplaces from maintaining physical possession or control of a customer's digital assets except for the purpose of effecting a specific transaction; and • Requiring digital asset brokers and digital asset investment advisers to reimburse customers for self-reported "unauthorized digital asset transfers,"[25] including transfers effected without the customer's actual authorization and transfers resulting from fraud. The proposal imposes registration requirements for digital asset issuers, digital asset brokers, digital asset marketplaces, digital asset investment advisers and digital asset influencers. Specifically, the proposal would require every digital asset issuer, digital asset broker, digital asset marketplace and digital asset investment adviser to file a registration statement with the attorney general's office prior to engaging in business from or within New York state. In addition, the proposal would require digital asset influencers to register with the attorney general and to submit disclosures prior to engaging in any promotion of a digital asset. Existing BitLicenses would not be exempt from the proposal's registration requirements. The proposal also would codify the DFS' authority to supervise and examine entities licensed under the BitLicense regime as well as digital asset issuers, brokers, marketplaces and investment advisers that file a registration statement with the attorney general's office. The DFS would be authorized to examine each such entity as if they were a licensee under the BitLicense regime. This means that each entity would be examined no less than once every two calendar years to determine, among other things, the financial condition of the entity, the safety and soundness of its business, the policies of its management, and whether the entity has complied with the requirements of applicable laws, rules and regulations.[26] Finally, the proposal would grant the attorney general, in addition to its powers under existing law, jurisdiction to enforce any violation of the law; issue subpoenas; impose civil penalties of $10,000 per violation per individual or $100,000 per violation per firm; collect restitution, damages and penalties; and shut down businesses for fraud and other illegalities. Looking Forward State legislatures have become increasingly active in regulating the digital asset industry. So far in 2023, 39 states have passed or have some form of pending legislation affecting the digital asset industry, mostly centered on customer protection.[27] Recently enacted legislation has ranged from minor changes to include digital assets under the unclaimed property laws and the enactment of new digital asset education programs to significant changes to state regulation of digital assets, state money transmission laws and state commercial codes.[28] The proposal is another example of state leaders remaining focused on the digital asset industry and concerned with certain aspects of its practices. Given New York state's prominence both in the digital asset industry and as a proving ground for state regulatory innovation, all digital asset industry participants should take this proposal seriously. Digital asset industry participants to whom this proposal would apply should assess the proposal's requirements against their existing practices and evaluate the impact this proposal might have on the way they operate their business. They should also consider actively engaging in the legislative process to ensure that New York state lawmakers are fully informed about any issues or concerns about the proposal.
